Module V - Management Accounting and Financial Statement
Meaning, function, scope, utility, limitations & tools of management accounting. Analysis of
financial statement – Ratios.
INTRODUCTION
Management accounting can be viewed as Management-oriented Accounting. Basically it is
the study of managerial aspect of financial accounting, "accounting in relation to management
function". It shows how the accounting function can be re-oriented so as to fit it within the
framework of management activity. The primary task of management accounting is, therefore,
to redesign the entire accounting system so that it may serve the operational needs of the
firm. If furnishes definite accounting information, past, present or future, which may be used as
a basis for management action. The financial data are so devised and systematically
development that they become a unique tool for management decision.
DEFINITIONS OF MANAGEMENT ACCOUNTING
The term “Management Accounting”, observe, covers all those services by which the
accounting department can assist the top management and other departments in the
formation of policy, control of execution and appreciation of effectiveness. This definition
points out that management is entrusted with the primary task of planning, execution and control
of the operating activities of an enterprise. It constantly needs accounting information on which
to base its decision. A decision based on data is usually correct and the risk of erring is
minimized. It supplies all sorts of accounting information in the form of such statements as may
be needed by the management. Therefore, management accounting is concerned with the
accumulation, classification and interpretation of information that assists individual
executives to fulfill organizational objectives.
The Report of the Anglo-American Council of Productivity (1950) has also given a definition
of management accounting, which has been widely accepted. According to it, "Management
accounting is the presentation of accounting information in such a way as to assist the
management in creation of policy and the day to day operation of an undertaking". The
reasoning added to this statement was, "the technique of accounting is of extreme importance
because it works in the most nearly universal medium available for the expression of facts, so
that facts of great diversity can be represented in the same picture. It is not the production of
these pictures that is a function of management but the use of them." An analysis of the
above definition shows that management needs information for better decision-making and
effectiveness. The collection and presentation of such information come within the area of
management accounting. The accounting data so supplied thus provide the informational basis of
action. The quality of information so supplied depends upon its usefulness to management in
decision-making. It is to be understood here that the accounting information has no end in
itself; it is a means to an end. As its basic idea is to serve the management, its form and
frequency are all decided by managerial needs. Therefore, accounting aids the management by
providing quantitative information on the economic wellbeing of the enterprise. It would be
appropriate if we called management accounting an Enterprise Economics. Its scope extends to
the use of certain modern sophisticated managerial techniques in analyzing and interpreting
operative data and to the establishment of a communication network for financial
reporting at all managerial levels of an organization.
Brown and Howard stated that “Management Accounting is concerned with the efficient
management of a business through the presentation to management of such information that will
facilitate efficient planning and control”.
Development of Management Accounting as a subject
The area of organizational movement covered by management accounting has developed through
four identifiable stages. Stage one is earlier to 1950. Its focus was on cost determination and
financial control, through the use of budgeting and cost accounting technologies. Stage two
belonged to the period of 1965. During this stage, main focus had shifted to the provision of
information for management planning and control, through the use of such technologies as
decision analysis and responsibility accounting. Stage 3 was the period of 1985 in which main
concentration on the lessening of waste in resources used in business processes, through the
use of process analysis and cost management technologies and Stage four belonged to 1995, in
which attention had shifted to the creation of value through the effective use of resources,
through the use of technologies which scrutinize the drivers of customer value, shareholder
value, and organizational improvement.
Evolutionary stages of management accounting (Source: IFAC, 1998):
FUNCTIONS OF MANAGEMENT ACCOUNTING
The basic function of management accounting is to assist the management in performing its
functions effectively. The functions of the management are planning, organizing, directing and
controlling. Management accounting helps in the performance of each of these functions in the
following ways:
(i) Provides data: Management accounting serves as a vital source of data for management
planning. The accounts and documents are a repository of a vast quantity of data about the
past progress of the enterprise, which are a must for making forecasts for the future.
(ii) Modifies data: The accounting data required for managerial decisions is properly compiled
and classified. For example, purchase figures for different months may be classified to know
total purchases made during each period product-wise, supplier-wise and territory-wise.
(iii) Analyses and interprets data: The accounting data is analyzed meaningfully for
effective planning and decision-making. For this purpose the data is presented in a
comparative form. Ratios are calculated and likely trends are projected.
(iv) Serves as a means of communicating: Management accounting provides a means of
communicating management plans upward, downward and outward through the organization.
Initially, it means identifying the feasibility and consistency of the various segments of the plan.
At later stages it keeps all parties informed about the plans that have been agreed upon and their
roles in these plans.
(v) Facilitates control: Management accounting helps in translating given objectives and
strategy into specified goals for attainment by a specified time and secures effective
accomplishment of these goals in an efficient manner. All this is made possible through
budgetary control and standard costing which is an integral part of management accounting.
(vi) Uses also qualitative information: Management accounting does not restrict itself to
financial data for helping the management in decision making but also uses such information
which may not be capable of being measured in monetary terms. Such information may be
collected form special surveys, statistical compilations, engineering records, etc.
SCOPE OF MANAGEMENT ACCOUNTING
Management accounting is concerned with presentation of accounting information in the most
useful way for the management. Its scope is, therefore, quite vast and includes within its fold
almost all aspects of business operations. However, the following areas can rightly be
identified as falling within the ambit of management accounting:
(i) Financial Accounting: Management accounting is mainly concerned with the
rearrangement of the information provided by financial accounting. Hence, management
cannot obtain full control and coordination of operations without a properly designed
financial accounting system.
(ii) Cost Accounting: Standard costing, marginal costing, opportunity cost analysis, differential
costing and other cost techniques play a useful role in operation and control of the business
undertaking.
(iii) Revaluation Accounting: This is concerned with ensuring that capital is maintained
intact in real terms and profit is calculated with this fact in mind.
(iv) Budgetary Control: This includes framing of budgets, comparison of actual
performance with the budgeted performance, computation of variances, finding of their
causes, etc.
(v) Inventory Control: It includes control over inventory from the time it is acquired till its
final disposal.
(vi) Statistical Methods: Graphs, charts, pictorial presentation, index numbers and other
statistical methods make the information more impressive and intelligible.
(vii) Interim Reporting: This includes preparation of monthly, quarterly, half-yearly
income statements and the related reports, cash flow and funds flow statements, scrap reports,
etc.
(viii) Taxation: This includes computation of income in accordance with the tax laws, filing
of returns and making tax payments.
(ix) Office Services: This includes maintenance of proper data processing and other office
management services, reporting on best use of mechanical and electronic devices.
(x) Internal Audit: Development of a suitable internal audit system for internal control
Importance of Management Accounting
In complex business, it is imperative to perform systematic management planning. Delegation of
authority and decentralization of decision-making process has become important to conduct
business. The functions of management are no longer private. A system of information is
required to assist the management to investigate, evaluate and verify the functioning of each
division or unit for decision-making to accomplish the goals of the business. Management
Accounting has great importance to fulfill the needs of the management. Management
Accounting measures and reports appropriate information to the management and
facilitates in accomplishing corporate objectives. It is significant that the information given to
the management should be pertinent and issue based to facilitate the management to focus on the
real issue to reach at a specific conclusion. Management accounting on the basis of the
information available decide its goal and tries to realize the way through which it can reach the
objective.
Major benefits of Management Accounting
Management accounting helps in offering better Services to Customers. The cost control
device is management accounting that facilitates in reduction in prices of the Product. It helps
in making judgment. It is process of measuring performance. The techniques of budgetary
control standard costing enable the measurement of performance. In standard costing, standards
are decided and then actual cost is compared with standard cost. It facilitates the management
to find out deviations between standard cost and actual cost. Management accounting
increase efficiency of the business. The targets of different departments of the enterprise are
determined in advance and the accomplishment of these goals is taken as a device to gauge their
competence. Management accounting serves as effective management control. The Tools and
techniques of the management accounting are supportive to the management in planning
controlling and coordinating activities of the business, getting of standard and assessing actual
performance. Through management accounting, firms get maximum profits. In this process,
every possible effort is made to control unnecessary expenses. Management accounting gives
safety and security from trade cycle. The Information received from the management accounting
gives information over the past trade cycle. The management tries to determine the Causes of
trade cycle and its influence. Consequently, management accounting tries to defend the
organization from the effect of trade cycle.
LIMITATIONS OF MANAGEMENT ACCOUNTING
Management accounting, being comparatively a new discipline, suffers from certain limitations,
which limit its effectiveness. These limitations are as follows:
1. Limitations of basic records: Management accounting derives its information from financial
accounting, cost accounting and other records. The strength and weakness of the
management accounting, therefore, depends upon the strength and weakness of these basic
records. In other words, their limitations are also the limitations of management accounting.
2. Persistent efforts. The conclusions draws by the management accountant are not executed
automatically. He has to convince people at all levels. In other words, he must be an efficient
salesman in selling his ideas.
3. Management accounting is only a tool: Management accounting cannot replace the
management. Management accountant is only an adviser to the management. The decision
regarding implementing his advice is to be taken by the management. There is always a
temptation to take an easy course of arriving at decision by intuition rather than going by the
advice of the management accountant.
4. Wide scope: Management accounting has a very wide scope incorporating many disciplines.
It considers both monetary as well as non-monetary factors. This all brings inexactness and
subjectivity in the conclusions obtained through it.
5. Top-heavy structure: The installation of management accounting system requires heavy
costs on account of an elaborate organization and numerous rules and regulations. It can,
therefore, be adopted only by big concerns.
6. Opposition to change: Management accounting demands a break away from traditional
accounting practices. It calls for a rearrangement of the personnel and their activities, which
is generally not like by the people involved.
7. Evolutionary stage: Management accounting is still in its initial stage. It has, therefore, the
same impediments as a new discipline will have, e.g., fluidity of concepts, raw techniques and
imperfect analytical tools.
This all creates doubt about the very utility of management accounting.
Accounting Ratios
Financial statements aim at providing financial information about a business enterprise to
meet the information needs of the decision-makers. Financial statements prepared by a
business enterprise in the corporate sector are published and are available to the decision-makers.
These statements provide financial data which require analysis, comparison and
interpretation for taking decision by the external as well as internal users of accounting
information. The act is termed as financial statement analysis. It is regarded as an integral and
important part of accounting. The most commonly used techniques of financial statement,
analysis are comparative statements, common size statements, trend analysis, accounting
ratios and cash flow analysis. The technique of accounting ratios for analysing the information
contained in financial statements is used for assessing the solvency, efficiency and profitability
of the firms.
Meaning of Accounting Ratios
As stated earlier, accounting ratios are an important tool of financial statement analysis. A ratio
is a mathematical number calculated as a reference to relationship of two or more numbers
and can be expressed as a fraction, proportion, percentage, and a number of times. When
the number is calculated by referring to two accounting numbers derived from the financial
statements, it is termed as accounting ratio.
For example if the gross profit of the business is Rs. 10,000 and the sales are Rs. 1,00,000, it can
be said that the gross profit is 10% (10,000/1,00,000) of the sales. This ratio is termed as gross
profit ratio.
Similarly, inventory turnover ratio may be 6 which imply that inventory turns into sales six
times in a year. It needs to be observed that accounting ratios exhibit relationship, if any
between accounting numbers extracted from financial statements, they are essentially derived
numbers and their efficacy depends a great deal upon the basic numbers from which they are
calculated. Hence, if the financial statements contain some errors, the derived numbers in terms
of ratio analysis would also present an erroneous scenario.
Further, a ratio must be calculated using numbers which are meaningfully correlated. A ratio
calculated by using two unrelated numbers would hardly serve any purpose. For example,
the furniture of the business is Rs. 1,00,000 and Purchases are Rs. 3,00,000. The ratio of
purchases to furniture is 3 (3,00,000/1,00,000) but it hardly has any relevance. The reason is that
there is no relationship between these two aspects.
Objectives of Ratio Analysis
Ratio analysis is indispensable part of interpretation of results revealed by the financial
statements. It provides users with crucial financial information and points out the areas which
require investigation. Ratio analysis is a technique, which involves regrouping of data by
application of arithmetical relationships, though its interpretation is a complex matter. It
requires a fine understanding of the way and the rules used for preparing financial statements.
Once done effectively, it provides a wealth of information which helps the analyst:
1. To know the areas of the business which need more attention.
2. To know about the potential areas which can be improved with the effort in the desired
direction.
3. To provide a deeper analysis of the profitability, liquidity, solvency and efficiency levels in
the business.
4. To provide information for making cross sectional analysis by comparing the performance
with the best industry standards.
5. To provide information derived from financial statements useful for making projections and
estimates for the future.
Advantages of Ratio Analysis
The ratio analysis if properly done improves the user’s understanding of the efficiency with
which the business is being conducted. The numerical relationships throw light on many latent
aspects of the business. If properly analysed, the ratios make us understand various problem
areas as well as the bright spots of the business. The knowledge of problem areas helps
management take care of them in future. The knowledge of areas which are working better helps
you improve the situation further. It must be emphasised that ratios are means to an end
rather than the end in themselves. Their role is essentially indicative and that of a whistle
blower. There are many advantages derived from the ratio analysis. These are summarised as
follows:
1. Helps understand efficacy of decisions: The ratio analysis helps you understand whether the
business firm has taken the right kind of operating, investing and financing decisions. It
indicates how far they have helped in improving the performance.
2. Simplify complex figures and establish relationships: Ratios help in simplifying the
complex accounting figures and bring out their relationships. They help summaries the
financial information effectively and assess the managerial efficiency, firm‟s credit worthiness,
earning capacity, etc.
3. Helpful in comparative analysis: The ratios are not being calculated for one year only. When
many year figures are kept side by side, they help a great deal in exploring the trends visible
in the business. The knowledge of trend helps in making projections about the business which is
a very useful feature.
4. Identification of problem areas: Ratios help business in identifying the problem areas as
well as the bright areas of the business. Problem areas would need more attention and bright
areas will need polishing to have still better results.
5. Enables SWOT analysis: Ratios help a great deal in explaining the changes occurring in the
business. The information of change helps the management a great deal in understanding the
current threats and opportunities and allows business to do its own SWOT (Strength
Weakness-Opportunity-Threat) analysis.
6. Various comparisons: Ratios help comparisons with certain bench marks to assess as to
whether firm, performance is better or otherwise. For this purpose, the profitability, liquidity,
solvency, etc. of a business may be compared: (i) over a number of accounting periods with itself
(Intra-firm Comparison/Time Series Analysis), (ii) with other business enterprises (Inter-firm
Comparison/Cross-sectional Analysis), and (iii) with standards set for that firm/industry
(comparison with standard (or industry) expectations).
Limitations of Ratio Analysis
Since the ratios are derived from the financial statements, any weakness in the original financial
statements will also creep in the derived analysis in the form of ratio analysis. Thus, the
limitations of financial statements also form the limitations of the ratio analysis. Hence, to
interpret the ratios, the user should be aware of the rules followed in the preparation of financial
statements and also their nature and limitations. The limitations of ratio analysis which arise
primarily from the nature of financial statements are as under:
1. Limitations of Accounting Data: Accounting data give an unwarranted impression of
precision and finality. In fact, accounting data “reflect a combination of recorded facts,
accounting conventions and personal judgments and the judgments and conventions applied
affect them materially. For example, profit of the business is not a precise and final figure. It
is merely an opinion of the accountant based on application of accounting policies. The
soundness of the judgment necessarily depends on the competence and integrity of those who
make them and on their adherence to Generally Accepted Accounting Principles and
Conventions”. Thus, the financial statements may not reveal the true state of affairs and so the
ratios will also not give the true picture.
2. Ignores Price-level Changes: The financial accounting is based on stable money
measurement principle. It implicitly assumes that price level changes are either non-existent
or minimal. But the truth is otherwise. We are normally living in inflationary economies where
the power of money declines constantly. A change in the price level makes analysis of financial
statement of different accounting years meaningless because accounting records ignore
changes in value of money.
3. Ignore Qualitative or Non-monetary Aspects: Accounting provides information about
quantitative (or monetary) aspects of business. Hence, the ratios also reflect only the monetary
aspects, ignoring completely the non-monetary (qualitative) factors.
4. Variations in Accounting Practices: There are differing accounting policies for valuation of
stock, calculation of depreciation, treatment of intangibles, definition of certain financial
variables, etc. available for various aspects of business transactions. These variations leave a big
question mark on the cross sectional analysis. As there are variations in accounting practices
followed by different business enterprises, a valid comparison of their financial statements
is not possible.
5. Forecasting: Forecasting of future trends based only on historical analysis is not feasible.
Proper forecasting requires consideration of non-financial factors as well.
Now let us talk about the limitations of the ratios. The various limitations are:
1. Means and not the End: Ratios are means to an end rather than the end by itself.
2. Lack of ability to resolve problems: Their role is essentially indicative and of whistle
blowing and not providing a solution to the problem.
3. Lack of standardised definitions: There is a lack of standardised definitions of various
concepts used in ratio analysis. For example, there is no standard definition of liquid
liabilities. Normally, it includes all current liabilities, but sometimes it refers to current liabilities
less bank overdraft.
4. Lack of universally accepted standard levels: There is no universal yardstick which
specifies the level of ideal ratios. There is no standard list of the levels universally acceptable,
and, in India, the industry averages are also not available.
5. Ratios based on unrelated figures: A ratio calculated for unrelated figures would essentially
be a meaningless exercise. For example, creditors of Rs. 1,00,000 and furniture of Rs. 1,00,000
represent a ratio of 1:1. But it has no relevance to assess efficiency or solvency.
Hence, ratios should be used with due consciousness of their limitations while evaluating the
performance of an organisation and planning the future strategies for its improvement.
Types of Ratios
There is a two way classification of ratios:
(1) Traditional classification (2) functional classification
The traditional classification has been on the basis of financial statements to which the
determinants of ratios belong. On this basis the ratios are classified as follows:
1. Income Statement Ratios: A ratio of two variables from the income statement is known as
Income Statement Ratio. For example, ratio of gross profit to sales known as gross profit ratio is
calculated using both figures from the income statement.
2. Balance Sheet Ratios: In case both variables are from balance sheet, it is classified as
Balance Sheet Ratios. For example, ratio of current assets to current liabilities known as current
ratio is calculated using both figures from balance sheet.
3. Composite Ratios: If a ratio is computed with one variable from income statement and
another variable from balance sheet, it is called Composite Ratio. For example, ratio of
credit sales to debtors and bills receivable known as debtor turnover ratio is calculated using
one figure from income statement (credit sales) and another figure from balance sheet (debtors
and bills receivable).
Although accounting ratios are calculated by taking data from financial statements but
classification of ratios on the basis of financial statements is rarely used in practice. It must
be recalled that basic purpose of accounting is to throw useful light on the financial
performance (profitability) and financial position (its capacity to raise money and invest them
wisely) as well as changes occurring in financial position (possible explanation of changes in the
activity level). As such, the alternative classification (functional classification) based on the
purpose, for which a ratio is computed, is the most commonly used classification which
reaches as follows:
1. Liquidity Ratios: To meet its commitments, business needs liquid funds. The ability of the
business to pay the amount due to stakeholders as and when it is due is known as liquidity,
and the ratios calculated to measure it are known as ‘Liquidity Ratios’. They are essentially
short-term in nature.
2. Solvency Ratios: Solvency of business is determined by its ability to meet its contractual
obligations towards stakeholders, particularly towards external stakeholders, and the ratios
calculated to measure solvency position are known as ‘Solvency Ratios’. They are essentially
long-term in nature, and
3. Activity (or Turnover) Ratios: This refers to the ratios that are calculated for measuring
the efficiency of operation of business based on effective utilisation of resources. Hence,
these are also known as „efficiency ratios‟.
4. Profitability Ratios: It refers to the analysis of profits in relation to sales or funds (or
assets) employed in the business and the ratios calculated to meet this objective are known as
„Profitability Ratios‟.